My observations for one of the classes I teach regarding foreign outsourcing.
The China syndrome question was specifically structured so that we focused on the economic question, rather than the political or social issues behind it, which frankly are more important. Let us deal with the economic question first. There really is no issue as to what should be done from an economic standpoint. The goal of the firm is to maximize stream of profits over the long term. If, as a consultant, you gave advice other than that they would probably take away your consultant’s magic decoder ring. An argument can be made that businesses as a whole are hurt when some industries who oversees. I'm not sure that's a winning argument, but it's one that you could make.
Certainly if you look at the question from a macroeconomic perspective, one of the things you have to be aware of is issues of balance of trade and currency fluctuations. However, your question was specifically in dealing with the individual firm. This raises an interesting question which we will explore later in the course in the chapter about game theory. There is a conundrum and a paradox, involving the firm doing what is best for it individually without regards to another party’s actions. It is very possible that an action exists that collectively would be best for all involved, but that the solution cannot be reached because the individual outcomes threaten to be poor.
In my professional life I have always been a free-market thinker. I don't think I've ever been fanatical about the position; it just seems to me that on the whole the freer the markets the better the outcome. My faith in that has been shaken by two things: the rise of Wal-Mart, and the economic crisis in banking and money over the past three years.
Let's look first at Wal-Mart. Wal-Mart, in reacting to the marketplace and by gaining huge economies of scale, dominates the retail scene. There are some reasons for this that are not self-evident. Originally Wal-Mart’s competitive advantage existed in their logistics. Sam Walton, after opening up his initial store, opened up stores in the areas of his suppliers (or the route to and from them). In taking care where he placed his stores, his trucks could run one way full of product for his stores, and run back with product from his suppliers. That was the rule for his expansions over the first few years of Wal-Mart's growth. He also chose not to go head-to-head with firms in heavily populated areas, but instead chose to concentrate on the semi-urban and rural market. This brought about two specific advantages. The first was he didn't need to compete quite so strongly on the basis of price. While Wal-Mart was always price competitive, getting into an urban market might have forced their competitors to compete on a price basis, and when Wal-Mart was first beginning, they didn't want to face that challenge to their margins. The second advantage of placing the stores in rural or small-town areas was that real estate was considerably cheaper. There are also two other things that Wal-Mart has always done very well. The first is to allow the local managers some latitude of pricing product that is not selling (and to meet local competition). The second real advantage is their IT system – they always know how much product they have, where it is, how it is moving, and at what point should they re-order.
As Wal-Mart has gotten bigger, their advantage has been their sheer size relative to their suppliers. If you sell to Wal-Mart, you sell on their terms. They will pay you when they want to pay you, and they pretty much will negotiate favorable terms from all their suppliers.
As far as this goes their success is a great example of the market producing a favorable outcome, which is lower consumer prices. There are at least two significant downsides to the Wal-Mart story. I think the first is apparent to most of us, and that is that Wal-Mart’s presence has put such intense pressure on the local scene as to force thousands of retailers out of business. There is, of course, a side that says this is also an efficiency of the market, those stores that could not be competitive should be forced out, because at least theoretically the model of supply and demand forces out the weak players. (By the way this is not economic nor social Darwinism, the concept which I find chilling and repulsive ). Joseph Schumpeter discussed business cycles as being the process of creative destruction. Inefficient businesses or businesses that produce a product that is no longer wanted or no longer wanted in those quantities are forced out of business or forced to change the way they do business, especially in hard economic times. New businesses, and new products, are frequently the product of a recession. The theory is that the fat is cut out of the system.
There a couple issues here which need to be dealt with. The first is fairly muddy, and frankly a question I don't have the answer to. From a strict economic sense we want the most efficient producers, and the lowest cost producers. However, it is readily apparent that the evisceration of small-town America has been the product of Wal-Mart's prowess. There is certainly something to be said for businesses that are locally run and owned, that are part of the fabric of the community. There is a danger in any situation where one employer dominates the market. I am familiar with this issue having grown up in Battle Creek, Michigan where Kellogg was king. Kellogg no longer makes cereal in Battle Creek to any extent (although their world headquarters is still there). The jobs that were there for people with only high school degrees are gone. This of course is true with all the auto industry in the Midwest. Having Wal-Mart dominates the local employment scene makes towns vulnerable to any issues that Wal-Mart might have, and before you say that the Fortress Wal-Mart cannot go down, I have two words for you: General Motors. The second issue, of course, is that any type of monopoly power over the local economy and employment scene could (and probably does) cause wages to be artificially depressed. Wal-Mart is notorious for treating their employees poorly from a wage perspective. This is another case where the market tells us that the labor market is the same as any other market, and if Wal-Mart's wages are what the market will bear, then that is the correct wage. However, as we have learned, monopoly power causes deleterious effects, and could cause buyers to deal with the depressed offerings. Of course there is also the question of forcing everyone out of business and then raising your price. I have actually not read evidence of that, but it is certainly possible.
The other issue that as little as obvious with Wal-Mart's dominance is that their ability to negotiate price and terms causes the same effect to their suppliers as their price dominance does to their competitors in the local market. They in effect are driving margins down for suppliers, and forcing some of them out of business. They also have a negative effect on the ability of other buyers to deal with those same suppliers. At least theoretically if a certain margin is required to key the business open, and Wal-Mart is depressing that margin by their buying power, and that margin has to come at the expense of other suppliers, and hence to those supplier’s suppliers.
What does this have to do with the price of tea in China, or the idea of using Chinese labor for productions? It is this: the market may tell us that the appropriate thing to do is to ship these jobs overseas. However, the cost of this in societal terms, and human terms, seems to be too great.
As I've noted before almost all economists believed in a free and unencumbered market, along with few or no barriers to trade. There are some legitimate economists who disagree with this, but this is pretty mainstream. There are number reasons for trade which are important to note when looking at the idea of producing a product of offshore. One difference is that of government policy within the home market. Internal taxes and constraints on the market may make one country a preferred producer over another. Moreover, some countries have industries that are supported by the government, which causes the presence or absence an industry to be artificially influenced.
Another reason for trade may be differences in demand. Right or wrong or otherwise, I'm thinking of the baby formula marketplace which is engendered such a controversy in Third World countries (cigarettes are another such product). Visualize a product that is no longer used extensively in advanced economy, but might well be used in a developing economy. This would be certainly a strong reason for trade.
Another reason for trade is certainly presence or absence of natural resources. Frankly, the presence or absence of natural resources is not a good indicator of national wealth. However, it is a good indicator of the ability to produce specific product. Let’s use a kind of silly hypothetical example let us think about what would happen if New York City decided that they're going to get into the coffee growing business, and let us also assume that their only competition was Columbia (the country, not the University). Columbia's advantage in having more tillable land is a good reason for New York not to cover Central Park with coffee bushes.
(The above example using “assume” reminds me of a joke about how an economist who is stranded on a desert island gets off the island. First, he assumes a boat).
Carrying the example of Columbia and coffee a bit further, their ability to process the coffee, to roast it, grind it, and do whatever it is you do with coffee would probably be cheaper per unit basis because of economies of scale. While Michigan and United States are no longer the only producers of cars, it is apparent that the huge investment in the physical plant for the manufacturing of cars is not something that every country can or should do. Besides, who wants to buy a car from Tibet named “The Yak”?
In the same line of thinking, differences in technology (and education) can produce a national advantage which allows one country to produce something cheaper and thus is a reason for trade. Like the auto industry's manufacturing plants, you need both economies of scale and technological know-how to produce a computer, or computer chip. For what it's worth, this would hold true of an activity such as American football. Replicating the system of development from high school through college in the National Football League would be expensive and unlikely.
To the issue of banks and the financial system meltdown, I believe the market failed not because of greed, but because of transparency, poor management, and poorly structured incentives. Had the financial instruments bought and sold been clearer, much (but not all) of the issue would have been taken care of. This issue still troubles me, because I can see nothing that has been done to solve this issue.
In closing, I would like to talk briefly cover a very important concept, which is the concept of Comparative Advantage. Comparative Advantage was, as best we know, first elucidated in David Ricardo's tome On the Principles of Political Economy and Taxation written in 1817, some 40 years after Adam Smith's Wealth of Nations (which by the way I would recommend reading if you have any intention of going on after your masters degree). Ricardo was a brilliant economist, and while some of his ideas are outdated (specifically his argument that all wealth in effect comes from land), his concept of comparative advantage still holds true and is still enlightening. (Other reading that you might find interesting in this line would be John Stuart Mill’s 1848 work titled Principles of Political Economy, and Mill’s 1821 Elements of Political Economy).Mills shows, rather convincingly, that if two countries produce two products, each should produce the product they are best at (and trade), even if one of the economies is significantly better than the other in producing both products!
